By Annaliese Train | Realtor®, JD, Menlo Park Buyer Specialist
People love selling real estate at a profit, but they generally hate paying the associated taxes. Fortunately, IRS Code §1031 allows investors to sell appreciated property and replace it with another property without current recognition of the gain. In other words, they get to sell now and pay the taxes later (if at all).
Typically, a real estate investor will sell or “relinquish” an investment property first, and then proceed with the purchase of a replacement property in order to capitalize on IRS Code § 1031, deferring capital gains taxes until a later time. As long as the investor identifies a qualifying replacement property within 45 days and closes on that purchase within 180 days after the close of the relinquished property, the investor is entitled to defer paying capital gains taxes. This is a logical approach for most real estate marketplaces where inventory is balanced with buyer activity.
In Silicon Valley, however, there is the hazard of selling first due to the shortage of potential replacement properties and the bidding wars that accompany those sales. The worst-case scenario is that you sell your investment property thinking you’ll be able to identify and close on a property within the 45-/180-day IRS guidelines, but find that impossible due to extremely low buying opportunities that match your replacement value budget (equal to or greater than the previously sold property) and investment goals (e.g., multi-family unit, commercial space, single-family residence rental). In a marketplace where multiple offers are the norm, prices can skyrocket and options may be more limited than anticipated. IRS rules are strict and 45 days can pass quickly, leaving the seller either with unattractive replacement options or with paying hundreds of thousands of dollars in capital gains taxes they could have otherwise postponed.
Briefly, a reverse exchange allows the investor to first buy the replacement property and then proceed with the sale of the current investment property (the relinquished property). Benefits include the ability to walk away from overpaying on the replacement. Pressure purchases are ill-advised, as it is much wiser to honor your budget and capture a property in line with recent sales comps versus getting caught in a bidding war because you were boxed in with no alternatives.
Once the replacement property has been acquired, it must be parked with an exchange accommodation titleholder (EAT). Then, the investor can proceed with the sale of the relinquished property. It’s important to note that the sale of the relinquished property must still occur within 180 days of the close of escrow on the replacement property, and the property that will be sold must be identified within 45 days.
One caution to mention with the reverse exchange is that banks generally will not loan to you personally because of debt-to-income ratios, and because you cannot hold title to both relinquished and replacement properties simultaneously, according to IRS rules. Therefore, all-cash purchases of the replacement property are preferred. However, you can create an LLC which borrows money from you and/or a bank to purchase the replacement property, and holds title to the newly acquired property until proceeds from the relinquished property will be used to pay off the replacement property held by the LLC. Depending on how you want to hold title, it can remain in the LLC or be transferred to yourself. Just be sure to watch for pre-payment loan penalties or restrictions on transfer of title that may accelerate the loan payment.
In summary, working with a real estate agent who is very familiar with reverse 1031 exchanges is crucial. At DeLeon Realty, we educate our investment clients on how a reverse 1031 exchange works and can benefit their desire to defer capital gain taxes to a later sale date, while maintaining income-generating real estate in their portfolios. The DeLeon Team will be there every step of the way to guide you through this process, working with your lender and other advisors as necessary. Our end result will be a successful financial transaction with great investment property added to your portfolio!